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Friday, June 01, 2007

"The Church of Economics Has Admitted and Even Rewarded Some Scholars Who Would have been Considered Heretics in Earlier Periods"

Continuing the discussion of heterodox economics, this is Daniel Kahneman with "A Psychological Perspective on Economics":

A Psychological Perspective on Economics, by Daniel Kahneman, AEA Papers and Proceedings, May 2003: My first exposure to the psychological assumptions of economics was in a report that Bruno Frey wrote on that subject in the early 1970’s. Its first or second sentence stated that the agent of economic theory is rational and selfish, and that his tastes do not change. I found this list quite startling, because I had been professionally trained as a psychologist not to believe a word of it. The gap between the assumptions of our disciplines appeared very large indeed.

Has the gap been narrowed in the intervening 30 years? A search through some introductory textbooks in economics indicates that if there has been any change, it has not yet filtered down to that level: the same assumptions are still in place as the cornerstones of economic analysis. However, a behavioral approach to economics has emerged in which the assumptions are not held sacrosanct. In the following I comment selectively on the developments with regard to the three assumptions, on both sides of the disciplinary divide.

I. Selfishness The clearest progress has occurred in correcting and elaborating the assumption of selfishness, and the progress has come entirely from developments in economics, where the invention of the ultimatum game (Werner Guth et al., 1982) had a great impact...

A considerable amount of evidence, drawn from two-person games and from public-goods experiments, suggests that many people, at least in the Western culture, start out trusting and benevolent and reciprocate both good and bad behaviors. ... Many people also have a propensity to punish, even at some costs to themselves, misbehaviors of one stranger toward another stranger. An important theoretical discovery is that the presence of a sufficient number of individuals with these motives in a population will turn individuals who do not have the same motives into apparent cooperators (Fehr et al., 2002).

The experimental and theoretical studies of selfishness that some economists have conducted represent a general advance for social science. They also represent a significant move in economics, beyond the model of economic agents that Amartya Sen (1977) famously labeled “rational fools.” Some of the agents in Fehr’s models are “opportunistic with guile” (OliverWilliamson, 1985), but their behavior is strongly constrained by the fact that they are compelled to interact with people who care about being treated fairly and are willing to do something about it.

II. Rationality No one ever seriously believed that all people have rational beliefs and make rational decisions all the time. The assumption of rationality is generally understood to be an approximation, which is made in the belief (or hope) that departures from rationality are rare when the stakes are significant, or that they will disappear under the discipline of the market. This belief is not shared by everyone: some economists have questioned both the idea that small deviations from rationality do not matter...

The standard of rationality in economics was, and remains, the maximization of subjective expected utility—a combination of von Neumann- Morgenstern preferences and a Bayesian belief structure. There have been important challenges to this definition of rationality. Both Maurice Allais (1953) and Daniel Ellsberg (1961) demonstrated preferences that violate expected utility theory but have considerable normative appeal. A rich literature has developed in attempts to formulate a theory of rational choice that will legitimize the Allais and Ellsberg patterns of preferences. Herbert Simon (1955) introduced the concepts of satisficing and bounded rationality, which can be interpreted as defining a realistic normative standard for an organism with a finite mind.

In the mid-1980’s Amos Tversky and I articulated a direct challenge to the rationality assumption itself, based on experimental demonstrations in which preferences were affected predictably by the framing of decision problems, or by the procedure used to elicit preferences (Tversky and Kahneman, 1986). We argued that the demonstrated susceptibility of people to framing effects violates a fundamental assumption of invariance... Unlike the paradoxes of expected-utility theory, violations of invariance cannot be defended as normative. Furthermore, these violations are not restricted to the laboratory. The labeling of taxes is an obvious example of framing (Ed J. McCaffery, 1994). The power of default options is another. Brigitte C. Madrian and Dennis F. Shea (2001) reported that the enrollment rate in 401(k) plans is close to 100 percent when enrollment is automatic, but if action is required to enroll, only about half the employees will join the plan within their first year of employment. The cost of the activity is hardly sufficient to rationalize this behavior.

The various questions that have been raised about the rationality assumption appear to have legitimized and encouraged the development of economic theories that model departures from economic rationality in specific contexts. There have been quite a few of those...

But the rationality model continues to provide the basic framework even for these models, in which the agents are “fully rational, except for ...” some particular deviation that explains a family of anomalies.

III. Unchanging Tastes and the Carriers of Utility Economists are thoroughly habituated to the sight of indifference maps, but for someone who has been trained as a psychologist they can be a source of puzzlement. It took me a long time to realize that the representation looked odd because I kept looking for an indication of the individual’s current position in the map. There is no such indication, of course, because this parameter is supposed to be irrelevant: preferences for final states of endowment are assumed to be stable over variations of current endowment. This assumption, called  reference independence by Tversky and Kahneman (1991) is the interpretation of unchanging tastes with which I am concerned here. As I will show below, reference-independence can also be viewed as an aspect of rationality. ... [discussion of prospect theory and related developments] ...

IV. Will the Gap Close Further? Much has happened in the conversation between economics and psychology over the last 25 years. The church of economics has admitted and even rewarded some scholars who would have been considered heretics in earlier periods, and conventional economic analysis is now being done with assumptions that are often much more psychologically plausible than was true in the past. However, the analytical methodology of economics is stable, and it will inevitably constrain the rapprochement between the disciplines. Whether or not psychologists find them odd and overly simple, the standard assumptions about the economic agent are in economic theory for a reason: they allow for tractable analysis. The constraint of tractability can be satisfied with somewhat more complex models, but the number of parameters that can be added is small. One consequence is that the models of behavioral economics cannot stray too far from the original set of assumptions. Another consequence is that theoretical innovations in behavioral economics may be destined to be noncumulative: when a new model is developed to account for an anomaly of the basic theory, the parameters that were modified in earlier models will often be restored to their original settings. Thus, it now appears likely that the gap between the views in the two disciplines has been permanently narrowed, but there are no immediate prospects of economics and psychology sharing a common theory of human behavior. ...

I went to a seminar today on the neural representations of expected value. The speaker was neuroscientist and psychologist Brian Knutson from Stanford. He began his talk by saying he had given lots of seminars to economists, and lots to psychologists, but today was the first time he had spoken with both departments in the audience at the same time.

    Posted by on Friday, June 1, 2007 at 08:10 PM in Economics, Methodology, Science | Permalink  TrackBack (1)  Comments (19)

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